Credit and Credibility: Risks to China’s Economic Resilience

Executive Summary In the past decade, China has seen the largest credit expansion by any country in over a century, yet the Chinese economy has not suffered a financial crisis or a sudden slowdown in growth. This study aims to explain why China’s economy has been so resilient and examine whether that pattern of stability could change.
The record-breaking expansion of China’s financial system has been an underappreciated contributor to the country’s economic outperformance over the past four decades. The foundations of China’s economic performance are the subject of Chapter 1 of this study. The banking system has added $29 trillion in new assets since 2008, equivalent to around one third of total global GDP. China’s financial system used to be inefficient but stable—it was funded conservatively, by deposits, and largely made loans to state-owned enterprises. But keeping the financial system growing at the fast pace seen in recent years has required extremely loose monetary and regulatory conditions, which altered those pillars of stability and created a fundamentally different outlook due to mounting systemic risks.
These are not just hypotheticals. In 2012, the fundamental stabilizers of China’s financial system started to weaken. A larger proportion of new funding came from non-deposit sources, including instruments offering higher interest rates, such as wealth management products (WMPs). In turn, new credit increasingly fueled the informal or “shadow” banking system, and regulators struggled to keep up with financial innovation. China started to face capital outflows as the exchange rate depreciated, creating new funding pressures. Both the assets and the liabilities of the financial system have become more vulnerable, and a deleveraging campaign that Beijing began in late 2016 is now exposing these risks. These attributes of China’s new system, and the process by which it developed in just the past few years, are the focus of Chapter 2.
Most countries that permit rapid credit expansions face financial crises or a sharp slowdown in the economy as risks in the financial system emerge. Many explanations have been put forward as to why this has not happened in China so far, primarily emphasizing economic factors: a high national savings rate and a low level of external debt.
We examine these leading explanations for China’s resilience in the middle chapters of the study. In Chapter 3 we look at the role of China’s high savings rate in facilitating the growth of credit and debt in China’s financial system and supporting fast growth of the economy in general. The exceptional volume of savings, and willingness of Chinese to save a high share of income each year, is perceived to permit authorities to manage financial stress by providing a pool of financial resources that can be reallocated within the system to prevent shortfalls where they occur. However, we conclude that Chinese savings are concentrated in areas that are increasingly difficult for authorities to reallocate, and that new policy reforms to increase Beijing’s power to redirect savings through the financial system—like tax reform—are years away from effective implementation. These are not near-term crisis management tools.
The other dominant hypothesis for why China has been able to grow so fast on debt for so long without precipitating a crisis is that it “only owes itself”—that is, that debt is held at home, and that external financing constraints play a relatively limited role. We unpack this argument in Chapter 4. While China has a low level of external debt, the credit volumes extended domestically carry major default risks, likely higher than would have been permitted by politically-unconnected offshore creditors. Analysts understate the frequency with which domestic financial disruptions have occurred in the past elsewhere in the world. Liquidity pressures among Chinese financial institutions at home will be no less challenging than external pressures. China’s central bank has a powerful arsenal of policy tools to provide funding to those in need, but this is no panacea, as there are serious transmission problems within China’s money markets. Besides, eliminating domestic risk is not the point. Financial reform requires the central bank to permit some risk to emerge to improve market-based pricing of capital. Permitting risks to emerge in a system in which defaults and bankruptcies have been rare is a new challenge China has not fully experienced in the modern era.
In addition to these economic factors, political explanations are sometimes advanced to explain why the risks engendered by China’s record-breaking economic expansion would be different from those in other countries. Our signature argument is that Beijing’s credibility in assuring markets of its ability to stabilize any systemic disruption, hard-fought and built-up in prior periods, is the key explanation for past resilience. The development of this track record is the focus of Chapter 5. The degree of administrative control Chinese officials exercise over key actors in the system is often cited as an intrinsic source of strength that can prevent asset selloffs from gaining momentum and creating systemic risk. But today, while Beijing can order administrative interventions in markets, authorities cannot always compel desired outcomes. The failed attempt to prop up the equity market in 2015, for example, begs questions about how Beijing would handle a broader slowdown in the property market.
These traditional explanations of China’s financial stability underestimate the vital importance of Beijing’s credibility in providing a sufficient government response to any financial stress. Credibility has been a powerful political asset reinforcing financial stability, but it is not intrinsic to China’s system. Credibility is a byproduct of a track record of successful and meaningful interventions defending investors’ interests, and this same credibility will be tested as China reforms its financial system and steps back from widespread implicit and explicit guarantees on assets, companies, and banks.
Threats to China’s financial stability are emerging now because the political bargain between Beijing and China’s households and investors is changing within an already large, risky, and complex financial system. Sustaining business as usual expectations about rising household incomes and standards of living would require government support for increasingly peripheral and risky financial asset markets; economic authorities are strongly reluctant to do this, but have continued to do so thus far out of necessity since current growth rates are treated as a categorical imperative. Credibility has helped Beijing to manage the typical consequences of rapid credit expansions, but this credibility is transient and will be taxed in the near future as financial reform proceeds. The changing benefits and costs of the China model—persistent growth today on the upside and the likely damage in the future from marked-down asset values and faltering potential GDP growth rates—are the subject of Chapter 6 of this study.
In the concluding Chapter 7, we consider the implications of the analysis for China and the United States. For China, our assessment means that a specific set of domestic problems—bank funding shortfalls, a series of bond defaults, or interbank money market crises, for instance—are the plausible triggers for a disruption of China’s pattern of stability, more so than any external factors. For the United States, that diagnosis of China’s problems has implications. Washington could not encourage maximum Chinese growth, even if it wanted to, without amplifying those mounting risks. U.S. officials should not expect its external policies to be the primary sources of pressure on Chinese policymaking, but rather that domestic Chinese risks are changing the outlook. Credit growth and hence GDP growth in China will be lower in the years ahead, one way or another. It is important to plan U.S. policy around that assumption and not a belief that China has discovered an alternative to due diligence. It has not.
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